introduction to modern economic growthintroduction to modern economic growth 6.9. taking stock 305...

Introduction to ModernEconomic Growth

Daron Acemoglu

Department of Economics,

Massachusetts Institute of Technology

Contents

Preface xi

Part 1. Introduction 1

Chapter 1. Economic Growth and Economic Development:The Questions 3

1.1. Cross-Country Income Differences 31.2. Income and Welfare 81.3. Economic Growth and Income Differences 111.4. Origins of Today’s Income Differences and World Economic Growth 141.5. Conditional Convergence 191.6. Correlates of Economic Growth 231.7. From Correlates to Fundamental Causes 261.8. The Agenda 291.9. References and Literature 32

Chapter 2. The Solow Growth Model 372.1. The Economic Environment of the Basic Solow Model 382.2. The Solow Model in Discrete Time 482.3. Transitional Dynamics in the Discrete Time Solow Model 612.4. The Solow Model in Continuous Time 662.5. Transitional Dynamics in the Continuous Time Solow Model 712.6. Solow Model with Technological Progress 792.7. Comparative Dynamics 922.8. Taking Stock 942.9. References and Literature 952.10. Exercises 97

Chapter 3. The Solow Model and the Data 1033.1. Growth Accounting 1033.2. Solow Model and Regression Analyses 1073.3. The Solow Model with Human Capital 1173.4. Solow Model and Cross-Country Income Differences: Regression

Analyses 1253.5. Calibrating Productivity Differences 135

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Introduction to Modern Economic Growth

3.6. Estimating Productivity Differences 1413.7. Taking Stock 1483.8. References and Literature 1503.9. Exercises 151

Chapter 4. Fundamental Determinants of Differences in EconomicPerformance 155

4.1. Proximate Versus Fundamental Causes 1554.2. Economies of Scale, Population, Technology and World Growth 1604.3. The Four Fundamental Causes 1634.4. The Effect of Institutions on Economic Growth 1784.5. What Types of Institutions? 1994.6. Disease and Development 2024.7. Political Economy of Institutions: First Thoughts 2064.8. Taking Stock 2074.9. References and Literature 2084.10. Exercises 211

Part 2. Towards Neoclassical Growth 213

Chapter 5. Foundations of Neoclassical Growth 2155.1. Preliminaries 2155.2. The Representative Household 2185.3. Infinite Planning Horizon 2265.4. The Representative Firm 2295.5. Problem Formulation 2325.6. Welfare Theorems 2335.7. Sequential Trading 2415.8. Optimal Growth in Discrete Time 2455.9. Optimal Growth in Continuous Time 2465.10. Taking Stock 2475.11. References and Literature 2485.12. Exercises 250

Chapter 6. Dynamic Programming and Optimal Growth 2556.1. Brief Review of Dynamic Programming 2566.2. Dynamic Programming Theorems 2606.3. The Contraction Mapping Theorem and Applications* 2666.4. Proofs of the Main Dynamic Programming Theorems* 2726.5. Fundamentals of Dynamic Programming 2806.6. Optimal Growth in Discrete Time 2916.7. Competitive Equilibrium Growth 2976.8. Another Application of Dynamic Programming: Search for Ideas 299

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6.9. Taking Stock 3056.10. References and Literature 3066.11. Exercises 307

Chapter 7. Review of the Theory of Optimal Control 3137.1. Variational Arguments 3147.2. The Maximum Principle: A First Look 3247.3. Infinite-Horizon Optimal Control 3307.4. More on Transversality Conditions 3427.5. Discounted Infinite-Horizon Optimal Control 3457.6. A First Look at Optimal Growth in Continuous Time 3517.7. The q-Theory of Investment 3527.8. Taking Stock 3597.9. References and Literature 3617.10. Exercises 363

Part 3. Neoclassical Growth 371

Chapter 8. The Neoclassical Growth Model 3738.1. Preferences, Technology and Demographics 3738.2. Characterization of Equilibrium 3788.3. Optimal Growth 3838.4. Steady-State Equilibrium 3848.5. Transitional Dynamics 3878.6. Technological Change and the Canonical Neoclassical Model 3908.7. Comparative Dynamics 3988.8. The Role of Policy 4008.9. A Quantitative Evaluation 4028.10. Extensions 4058.11. Taking Stock 4068.12. References and Literature 4078.13. Exercises 408

Chapter 9. Growth with Overlapping Generations 4179.1. Problems of Infinity 4189.2. The Baseline Overlapping Generations Model 4219.3. The Canonical Overlapping Generations Model 4279.4. Overaccumulation and Pareto Optimality of Competitive Equilibrium

in the Overlapping Generations Model 4299.5. Role of Social Security in Capital Accumulation 4339.6. Overlapping Generations with Impure Altruism 4369.7. Overlapping Generations with Perpetual Youth 4419.8. Overlapping Generations in Continuous Time 445

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Chapter 10. Human Capital and Economic Growth 46310.1. A Simple Separation Theorem 46310.2. Schooling Investments and Returns to Education 46610.3. The Ben Porath Model 46910.4. Neoclassical Growth with Physical and Human Capital 47410.5. Capital-Skill Complementarity in an Overlapping Generations Model 48010.6. Physical and Human Capital with Imperfect Labor Markets 48510.7. Human Capital Externalities 49210.8. Nelson-Phelps Model of Human Capital 49510.9. Taking Stock 49810.10. References and Literature 50010.11. Exercises 502

Chapter 11. First-Generation Models of Endogenous Growth 50511.1. The AK Model Revisited 50611.2. The AK Model with Physical and Human Capital 51311.3. The Two-Sector AK Model 51611.4. Growth with Externalities 52111.5. Taking Stock 52611.6. References and Literature 52811.7. Exercises 529

Part 4. Endogenous Technological Change 535

Chapter 12. Modeling Technological Change 53712.1. Different Conceptions of Technology 53712.2. Science, Profits and the Market Size 54212.3. The Value of Innovation in Partial Equilibrium 54512.4. The Dixit-Stiglitz Model and “Aggregate Demand Externalities” 55512.5. Individual R&D Uncertainty and the Stock Market 56212.6. Taking Stock 56412.7. References and Literature 56512.8. Exercises 567

Chapter 13. Expanding Variety Models 57113.1. The Lab Equipment Model of Growth with Product Varieties 57213.2. Growth with Knowledge Spillovers 58613.3. Growth without Scale Effects 58913.4. Growth with Expanding Product Varieties 593

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Chapter 14. Models of Competitive Innovations 60914.1. The Baseline Model of Competitive Innovations 61014.2. A One-Sector Schumpeterian Growth Model 62314.3. Step-by-Step Innovations* 62914.4. Taking Stock 64514.5. References and Literature 64614.6. Exercises 647

Chapter 15. Directed Technological Change 65515.1. Importance of Biased Technological Change 65615.2. Basics and Definitions 66015.3. Baseline Model of Directed Technological Change 66315.4. Directed Technological Change with Knowledge Spillovers 68115.5. Directed Technological Change without Scale Effects 68615.6. Endogenous Labor-Augmenting Technological Change 68815.7. Other Applications 69215.8. Taking Stock 69315.9. References and Literature 69415.10. Exercises 698

Part 5. Stochastic Growth 705

Chapter 16. Stochastic Dynamic Programming 70716.1. Dynamic Programming with Expectations 70716.2. Policy Functions and Transitions 70716.3. Few Technical Details* 70716.4. Applications of Stochastic Dynamic Programming 70716.5. Taking Stock 70716.6. References and Literature 70716.7. Exercises 707

Chapter 17. Neoclassical Growth Under Uncertainty 70917.1. The Brock-Mirman Model 70917.2. Equilibrium Growth under Uncertainty 71017.3. Application: Real Business Cycle Models 71017.4. Taking Stock 71017.5. References and Literature 71017.6. Exercises 710

Chapter 18. Growth with Incomplete Markets 711

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18.1. The Bewley-Aiyagari Model 71118.2. Risk, Diversification and Growth 71118.3. Taking Stock 71118.4. References and Literature 71118.5. Exercises 711

Part 6. Technology Diffusion, Trade and Interdependences 713

Chapter 19. Diffusion of Technology 71519.1. Importance of Technology Adoption and Diffusion 71519.2. A Benchmark Model of Technology Diffusion 71519.3. Human Capital and Technology 71519.4. Technology Diffusion and Endogenous Growth 71619.5. Appropriate Technology and Productivity Differences 71619.6. Inappropriate Technologies 71719.7. Endogenous Technological Change and Appropriate Technology 71819.8. Taking Stock 72319.9. References and Literature 72319.10. Exercises 723

Chapter 20. Trade, Technology and Interdependences 72520.1. Trade, Specialization and the World Income Distribution 72520.2. Trade, Factor Price Equalization and Economic Growth 73120.3. Trade, Technology Diffusion and the Product Cycle 73220.4. Learning-by-Doing, Trade and Growth 73620.5. Trade and Endogenous Technological Change 73620.6. Taking Stock 73620.7. References and Literature 73620.8. Exercises 736

Part 7. Economic Development and Economic Growth 737

Chapter 21. Structural Change and Economic Growth 73921.1. Non-Balanced Growth: The Demand Side 73921.2. Non-Balanced Growth: The Supply Side 74321.3. Structural Change: Migration 74321.4. Structural Change: Transformation of Productive Relationships 74321.5. Towards a Unified Theory of Development and Growth 74321.6. Taking Stock 74321.7. References and Literature 74321.8. Exercises 743

Chapter 22. Poverty Traps, Inequality and Financial Markets 74522.1. Multiple Equilibria From Aggregate Demand Externalities 745

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22.2. Human Capital Accumulation with Imperfect Capital Markets 75422.3. Income Inequality and Economic Development 76122.4. Financial Development and Economic Growth 76122.5. Taking Stock 76122.6. References and Literature 76122.7. Exercises 761

Chapter 23. Population Growth and the Demographic Transition 76323.1. Patterns of Demographic Changes 76323.2. Population and Growth: Different Perspectives 76323.3. A Simple Model of Demographic Transition 76323.4. Exercises 763

Part 8. Political Economy of Growth 765

Chapter 24. Institutions and Growth 76724.1. The Impact of Institutions on Long-Run Development 767

Chapter 25. Modeling Non-Growth Enhancing Institutions 77725.1. Baseline Model 78125.2. Technology Adoption and Holdup 79525.3. Inefficient Economic Institutions 79825.4. Exercises 802

Chapter 26. Modeling Political Institutions 80326.1. Understanding Endogenous Political Change 80326.2. Exercises 815

Part 9. Conclusions 817

Chapter 27. Putting It All Together: Mechanics and Causes of EconomicGrowth 819

Chapter 28. Areas of Future Research 821

Part 10. Mathematical Appendix 823

Chapter 29. Review of Basic Set Theory 82529.1. Open, Closed, Convex and Compact Sets 82529.2. Sequences, Subsequences and Limits 82529.3. Distance, Norms and Metrics 825

Chapter 30. Functions of Several Variables 82730.1. Continuous Functions 82730.2. Convexity, Concavity, Quasi-Concavity 827

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30.3. Taylor Series 82730.4. Optima and Constrained Optima 82730.5. Intermediate and Mean Value Theorems 82730.6. Inverse and Implicit Function Theorems 827

Chapter 31. Review of Ordinary Differential Equations 82931.1. Review of Complex Numbers 82931.2. Eigenvalues and Eigenvectors 82931.3. Linear Differential Equations 82931.4. Separable Differential Equations 82931.5. Existence and Uniqueness Theorems 829

References (highly incomplete) 831

x

Preface

This book is intended to serve two purposes:

(1) First and foremost, this is a book about economic growth and long-runeconomic development. The process of economic growth and the sourcesof differences in economic performance across nations are some of the mostinteresting, important and challenging areas in modern social science. Theprimary purpose of this book is to introduce graduate students to thesemajor questions and to the theoretical tools necessary for studying them.The book therefore strives to provide students with a strong backgroundin dynamic economic analysis, since only such a background will enable aserious study of economic growth and economic development. It also triesto provide a clear discussion of the broad empirical patterns and historicalprocesses underlying the current state of the world economy. This is moti-vated by my belief that to understand why some countries grow and somefail to do so, economists have to move beyond the mechanics of models andpose questions about the fundamental causes of economic growth.

(2) In a somewhat different capacity, this book is also a graduate-level intro-duction to modern macroeconomics and dynamic economic analysis. It issometimes commented that, unlike basic microeconomic theory, there is nocore of current macroeconomic theory that is shared by all economists. Thisis not entirely true. While there is disagreement among macroeconomistsabout how to approach short-run macroeconomic phenomena and what theboundaries of macroeconomics should be, there is broad agreement aboutthe workhorse models of dynamic macroeconomic analysis. These includethe Solow growth model, the neoclassical growth model, the overlapping-generations model and models of technological change and technology adop-tion. Since these are all models of economic growth, a thorough treatmentof modern economic growth can also provide (and perhaps should provide)an introduction to this core material of modern macroeconomics. Althoughthere are several good graduate-level macroeconomic textbooks, they typ-ically spend relatively little time on the basic core material and do notdevelop the links between modern macroeconomic analysis and economicdynamics on the one hand and general equilibrium theory on the other.

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In contrast, the current book does not cover any of the short-run top-ics in macroeconomics, but provides a thorough and rigorous introductionto what I view to be the core of macroeconomics. Therefore, the secondpurpose of the book is to provide a first graduate-level course in modernmacroeconomics.

The topic selection is designed to strike a balance between the two purposesof the book. Chapters 1, 3 and 4 introduce many of the salient features of theprocess of economic growth and the sources of cross-country differences in economicperformance. Even though these chapters cannot do justice to the large literatureon economic growth empirics, they provide a sufficient background for students toappreciate the set of issues that are central to the study of economic growth andalso a platform for a further study of this large literature.Chapters 5-7 provide the conceptual and mathematical foundations of modern

macroeconomic analysis. Chapter 5 provides the microfoundations for much of therest of the book (and for much of modern macroeconomics), while Chapters 6 and7 provide a quick but relatively rigorous introduction to dynamic optimization.Most books on macroeconomics or economic growth use either continuous time ordiscrete time exclusively. I believe that a serious study of both economic growth andmodern macroeconomics requires the student (and the researcher) to be able to gobetween discrete and continuous time and choose whichever one is more convenientor appropriate for the set of questions at hand. Therefore, I have deviated from thisstandard practice and included both continuous time and discrete time materialthroughout the book.Chapters 2, 8, 9 and 10 introduce the basic workhorse models of modern macroe-

conomics and traditional economic growth, while Chapter 11 presents the first gen-eration models of sustained (endogenous) economic growth. Chapters 12-15 covermodels of technological progress, which are an essential part of any modern economicgrowth course.Chapter 16 generalizes the tools introduced in Chapter 6 to stochastic envi-

ronments. Using these tools, Chapter 17 presents the canonical stochastic growthmodel, which is the foundation of much of modern macroeconomics (though it isoften left out of economic growth courses). This chapter also includes a discus-sion of the canonical Real Business Cycle model. Chapter 18 covers another majorworkhorse model of modern macroeconomics, the neoclassical growth model withincomplete markets. As well as the famous Bewley-Aiyagari model, this chapter dis-cusses a number of other approaches to modeling the interaction between incompletemarkets and economic growth.Chapters 19-23 cover a range of topics that are sometimes left out of economic

growth textbooks. These include models of technology adoption, technology diffu-sion, appropriate technology, interaction between international trade and technol-ogy, structural change, poverty traps, inequality, and population growth. These

xii


topics are important for creating a bridge between the empirical patterns we ob-serve in practice and the theory. Most traditional growth models consider a singleeconomy in isolation and often after it has already embarked upon a process ofsteady economic growth. A study of models that incorporate cross-country inter-dependences, structural change and the possibility of takeoffs will enable us to linkcore topics of development economics, such as structural change, poverty traps orthe demographic transition, to the theory of economic growth.Finally, Chapters 24-26 consider another topic often omitted from macroeco-

nomics and economic growth textbooks; political economy. This is motivated bythe belief that the study of economic growth would be seriously hampered if wefailed to ask questions about the fundamental causes of why countries differ intheir economic performances. These questions invariably bring us to differences ineconomic policies and institutions across nations. Political economy enables us todevelop models to understand why economic policies and institutions differ acrosscountries and must therefore be an integral part of the study of economic growth.

A few words on the philosophy and organization of the book might also beuseful for students and teachers. The underlying philosophy of the book is that allthe results that are stated should be proved or at least explained in detail. Thisimplies a somewhat different organization than existing books. Most textbooks ineconomics do not provide proofs for many of the results that are stated or invoked,and mathematical tools that are essential for the analysis are often taken for grantedor developed in appendices. In contrast, I have strived to provide simple proofs ofalmost all results stated in this book. It turns out that once unnecessary generalityis removed, most results can be stated and proved in a way that is easily accessibleto graduate students. In fact, I believe that even somewhat long proofs are mucheasier to understand than general statements made without proof, which leave thereader wondering about why these statements are true.I hope that the style I have chosen not only makes the book self-contained, but

also gives the students an opportunity to develop a thorough understanding of thematerial. In addition, I present the basic mathematical tools necessary for analy-sis within the main body of the text. My own experience suggests that a “linear”progression, where the necessary mathematical tools are introduced when needed,makes it easier for the students to follow and appreciate the material. Consequently,analysis of stability of dynamical systems, dynamic programming in discrete timeand optimal control in continuous time are all introduced within the main body ofthe text. This should both help the students appreciate the foundations of thetheory of economic growth and also provide them with an introduction to the maintools of dynamic economic analysis, which are increasingly used in every subdisci-pline of economics. Throughout, when some material is technically more difficultand can be skipped without loss of continuity, it is clearly marked with a “*”. The

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only material that is left for the Mathematical Appendix are those that should be fa-miliar to most graduate students. Therefore the Mathematical Appendix is includedmostly for reference and completeness.I have also included a large number of exercises. Students can only gain a

thorough understanding of the material by working through the exercises. Theexercises that are somewhat more difficult are also marked with a “*”.

This book can be used in a number of different ways. First, it can be used in aone-quarter or one-semester course on economic growth. Such a course might startwith Chapters 1-4, then use Chapters 5-7 either for a thorough study or only forreference. Chapters 8-11 cover the traditional growth theory. Then Chapters 12-15can be used for endogenous growth theory. Depending on time and interest, anyselection of Chapters 18 and 19-26 can be used for the last part of such a course.Second, the book can be used for a one-quarter first-year graduate-level course

in macroeconomics. In this case, Chapter 1 is optional. Chapters 8, 3, 5-7, 8-11 and16-18 would be the core of such a course. The same material could also be coveredin a one-semester course, but in this case, it could be supplemented either withsome of the later chapters or with material from one of the leading graduate-levelmacroeconomic textbooks on short-run macroeconomics, fiscal policy, asset pricing,or other topics in dynamic macroeconomics.Third, the book can be used for an advanced (second-year) course in economic

growth or economic development. An advanced course on growth or developmentcould use Chapters 1-11 as background and then focus on selected chapters fromChapters 19-26.Finally, since the book is self-contained, I also hope that it can be used for

self-study.

Acknowledgments. This book grew out of the first graduate-level introduc-tion to macroeconomics course I have taught at MIT. Parts of the book have alsobeen taught as part of a second-year graduate macroeconomics course. I would liketo thank the students who have sat through these lectures and made commentsthat have improved the manuscript. I owe a special thanks to Monica Martinez-Bravo, Samuel Pienknagura, Lucia Tian Tian and especially Alp Simsek for out-standing research assistance, to Lauren Fahey for editorial suggestions, and to PolAntras, George-Marios Angeletos, Olivier Blanchard, Simon Johnson, Chad Jones,and James Robinson for suggestions on individual chapters.

Please note that this is a very preliminary draft of the bookmanuscript. Comments are welcome.Version 1.1: April 2007

xiv

Part 1

Introduction

We start with a quick look at the stylized facts of economic growth and the most

basic model of growth, the Solow growth model. The purpose is both to prepare us

for the analysis of more modern models of economic growth with forward-looking

behavior, explicit capital accumulation and endogenous technological progress, and

also to give us a way of mapping the simplest model to data. We will also dis-

cuss differences between proximate and fundamental causes of economic growth and

economic development.

CHAPTER 1

Economic Growth and Economic Development:The Questions

1.1. Cross-Country Income Differences

There are very large differences in income per capita and output per worker

across countries today. Countries at the top of the world income distribution are

more than thirty times as rich as those at the bottom. For example, in 2000, GDP

(or income) per capita in the United States was over $33000. In contrast, income per

capita is much lower in many other countries: less than $9000 in Mexico, less than

$4000 in China, less than $2500 in India, and only about $700 in Nigeria, and much

much lower in some other sub-Saharan African countries such as Chad, Ethiopia,

and Mali. These numbers are all at 1996 US dollars and are adjusted for purchasing

power party (PPP) to allow for differences in relative prices of different goods across

countries. The gap is larger when there is no PPP-adjustment (see below).

We can catch a glimpse of these differences in Figure 1.1, which plots estimates of

the distribution of PPP-adjusted GDP per capita across the available set of countries

in 1960, 1980 and 2000. The numbers refer to 1996 US dollars and are obtained

from the Penn World tables compiled by Summers and Heston, the standard source

of data for post-war cross-country comparisons of income or worker per capita. A

number of features are worth noting. First, the 1960 density shows that 15 years

after the end of World War II, most countries had income per capita less than $1500

(in 1996 US dollars); the mode of the distribution is around $1250. The rightwards

shift of the distributions for 1980 and for 2000 shows the growth of average income

per capita for the next 40 years. In 2000, the mode is still slightly above $3000, but

now there is another concentration of countries between $20,000 and $30,000. The

density estimate for the year 2000 shows the considerable inequality in income per

capita today.

3


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Figure 1.1. Estimates of the distribution of countries according toPPP-adjusted GDP per capita in 1960, 1980 and 2000.

Part of the spreading out of the distribution in Figure 1.1 is because of the

increase in average incomes. It may therefore be more informative to look at the

logarithm of income per capita. It is more natural to look at the logarithm (log) of

variables, such as income per capita, that grow over time, especially when growth is

approximately proportional (e.g., at about 2% per year for US GDP per capita; see

Figure 1.8). Figure 1.2 shows a similar pattern, but now the spreading-out is more

limited. This reflects the fact that while the absolute gap between rich and poor

countries has increased considerably between 1960 and 2000, the proportional gap

has increased much less. Nevertheless, it can be seen that the 2000 density for log

GDP per capita is still more spread out than the 1960 density. In particular, both

figures show that there has been a considerable increase in the density of relatively

rich countries, while many countries still remain quite poor. This last pattern is

sometimes referred to as the “stratification phenomenon”, corresponding to the fact

4


1960

1980

2000

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f cou

tries

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Figure 1.2. Estimates of the distribution of countries according tolog GDP per capita (PPP-adjusted) in 1960, 1980 and 2000.

that some of the middle-income countries of the 1960s have joined the ranks of

relatively high-income countries, while others have maintained their middle-income

status or even experienced relative impoverishment.

While Figures 1.1 and 1.2 show that there is somewhat greater inequality among

nations, an equally relevant concept might be inequality among individuals in the

world economy. Figures 1.1 and 1.2 are not directly informative on this, since they

treat each country identically irrespective of the size of their population. The alter-

native is presented in Figure 1.3, which shows the population-weighted distribution.

In this case, countries such as China, India, the United States and Russia receive

greater weight because they have larger populations. The picture that emerges in

this case is quite different. In fact, the 2000 distribution looks less spread-out, with

thinner left tail than the 1960 distribution. This reflects the fact that in 1960 China

and India were among the poorest nations, whereas their relatively rapid growth in

5


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Figure 1.3. Estimates of the population-weighted distribution ofcountries according to log GDP per capita (PPP-adjusted) in 1960,1980 and 2000.

the 1990s puts them into the middle-poor category by 2000. Chinese and Indian

growth has therefore created a powerful force towards relative equalization of income

per capita among the inhabitants of the globe.

Figures 1.1, 1.2 and 1.3 look at the distribution of GDP per capita. While this

measure is relevant for the welfare of the population, much of growth theory will

focus on the productive capacity of countries. Theory is therefore easier to map to

data when we look at output per worker (GDP per worker). Moreover, as we will

discuss in greater detail later, key sources of difference in economic performance

across countries include national policies and institutions. This suggests that when

our interest is understanding the sources of differences in income and growth across

countries (as opposed to assessing welfare questions), the unweighted distribution

may be more relevant than the population-weighted distribution. Consequently,

6


1960

1980

2000

0.1

.2.3

.4D

ensi

ty o

f cou

tries

6 8 10 12log gdp per worker

Figure 1.4. Estimates of the distribution of countries according tolog GDP per worker (PPP-adjusted) in 1960, 1980 and 2000.

Figure 1.4 looks at the unweighted distribution of countries according to (PPP-

adjusted) GDP per worker. Since internationally comparable data on employment

are not available for a large number of countries, “workers” here refer to the to-

tal economically active population (according to the definition of the International

Labour Organization). Figure 1.4 is very similar to Figure 1.2, and if anything,

shows a bigger concentration of countries in the relatively rich tail by 2000, with

the poor tail remaining more or less the same as in Figure 1.2.

Overall, Figures 1.1-1.4 document two important facts: first, there is a large

inequality in income per capita and income per worker across countries as shown by

the highly dispersed distributions. Second, there is a slight but noticeable increase

in inequality across nations (though not necessarily across individuals in the world

economy).

7


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Figure 1.5. The association between income per capita and con-sumption per capita in 2000.

1.2. Income and Welfare

Should we care about cross-country income differences? The answer is undoubt-

edly yes. High income levels reflect high standards of living. Economic growth

might, at least over some range, increase pollution or raise individual aspirations, so

that the same bundle of consumption may no longer make an individual as happy.

But at the end of the day, when one compares an advanced, rich country with a

less-developed one, there are striking differences in the quality of life, standards of

living and health.

Figures 1.5 and 1.6 give a glimpse of these differences and depict the relationship

between income per capita in 2000 and consumption per capita and life expectancy

at birth in the same year. Consumption data also come from the Penn World

8


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SLV

SVKSVN

SWE

SWZ

SYR

TCD

TGO

THA

TJK

TTOTUN

TUR

TZA

UGA

UKR

URY

USA

VCTVEN

YEM ZAF

ZMB

ZWE

ETH

4050

6070

8090

life

expe

ctan

cy 2

000

6 7 8 9 10 11log gdp per capita 2000

Figure 1.6. The association between income per capita and life ex-pectancy at birth in 2000.

tables, while data on life expectancy at birth are available from the World Bank

Development Indicators.

These figures document that income per capita differences are strongly associ-

ated with differences in consumption (thus likely associated with differences in living

standards) and health as measured by life expectancy. Recall also that these num-

bers refer to PPP-adjusted quantities, thus differences in consumption do not (at

least in principle) reflect the fact that the same bundle of consumption goods costs

different amounts in different countries. The PPP adjustment corrects for these

differences and attempts to measure the variation in real consumption. Therefore,

the richest countries are not only producing more than thirty-fold as much as the

poorest countries, but they are also consuming thirty-fold as much. Similarly, cross-

country differences in health are nothing short of striking; while life expectancy at

9


birth is as high as 80 in the richest countries, it is only between 40 and 50 in many

sub-Saharan African nations. These gaps represent huge welfare differences.

Understanding how some countries can be so rich while some others are so poor

is one of the most important, perhaps the most important, challenges facing social

science. It is important both because these income differences have major welfare

consequences and because a study of such striking differences will shed light on how

economies of different nations are organized, how they function and sometimes how

they fail to function.

The emphasis on income differences across countries does not imply, however,

that income per capita can be used as a “sufficient statistic” for the welfare of the

average citizen or that it is the only feature that we should care about. As we will

discuss in detail later, the efficiency properties of the market economy (such as the

celebrated First Welfare Theorem or Adam Smith’s invisible hand) do not imply

that there is no conflict among individuals or groups in society. Economic growth is

generally good for welfare, but it often creates “winners” and “losers.” And major

idea in economics, Joseph Schumpeter’s creative destruction, emphasizes precisely

this aspect of economic growth; productive relationships, firms and sometimes indi-

vidual livelihoods will often be destroyed by the process of economic growth. This

creates a natural tension in society even when it is growing. One of the important

lessons of political economy analyses of economic growth, which will be discussed in

the last part of the book, concerns how institutions and policies can be arranged so

that those who lose out from the process of economic growth can be compensated

or perhaps prevented from blocking economic progress.

A stark illustration of the fact that growth does not mean increase in the liv-

ing standards of all or most citizens in a society comes from South Africa under

apartheid. Available data illustrate that from the beginning of the 20th century un-

til the fall of the apartheid regime, GDP per capita grew considerably, but the real

wages of black South Africans, who make up the majority of the population, fell dur-

ing this period. This of course does not imply that economic growth in South Africa

was not beneficial. South Africa still has one of the best economic performances in

sub-Saharan Africa. Nevertheless, it alerts us to other aspects of the economy and

also underlines the potential conflicts inherent in the growth process. These aspects

10


1960

1980

2000

05

1015

20D

ensi

ty o

f cou

tries

-.1 -.05 0 .05 .1average growth rates

Figure 1.7. Estimates of the distribution of countries according tothe growth rate of GDP per worker (PPP-adjusted) in 1960, 1980 and2000.

are not only interesting in and of themselves, but they also inform us about why

certain segments of the society may be in favor of policies and institutions that do

not encourage growth.

1.3. Economic Growth and Income Differences

How could one country be more than thirty times richer than another? The

answer lies in differences in growth rates. Take two countries, A and B, with the

same initial level of income at some date. Imagine that country A has 0% growth

per capita, so its income per capita remains constant, while country B grows at 2%

per capita. In 200 years’ time country B will be more than 52 times richer than

country A. Therefore, the United States is considerably richer than Nigeria because

it has grown steadily over an extended period of time, while Nigeria has not (and

11


SpainSouth Korea

India

Brazil

USA

Singapore

Nigeria

Guatemala

UK

Botswana

67

89

10lo

g gd

p pe

r cap

ita

1960 1970 1980 1990 2000year

Figure 1.8. The evolution of income per capita in the United States,United Kingdom, Spain, Singapore, Brazil, Guatemala, South Korea,Botswana, Nigeria and India, 1960-2000.

we will see that there is a lot of truth to this simple calculation; see Figures 1.8,

1.11 and 1.13).

In fact, even in the historically-brief postwar era, we see tremendous differences

in growth rates across countries. This is shown in Figure 1.7 for the postwar era,

which plots the density of growth rates across countries in 1960, 1980 and 2000. The

growth rate in 1960 refers to the (geometric) average of the growth rate between

1950 and 1969, the growth rate in 1980 refers to the average growth rate between

1970 and 1989 and 2000 refers to the average between 1990 and 2000 (in all cases

subject to data availability; all data from Penn World tables). Figure 1.7 shows

that in each time interval, there is considerable variability in growth rates; the

cross-country distribution stretches from negative growth rates to average growth

rates as high as 10% a year.

12


Figure 1.8 provides another look at these patterns by plotting log GDP per capita

for a number of countries between 1960 and 2000 (in this case, we look at GDP per

capita instead of GDP per worker both for data coverage and also to make the

figures more comparable to the historical figures we will look at below). At the top

of the figure, we see the US and the UK GDP per capita increasing at a steady pace,

with a slightly faster growth for the United States, so that the log (“proportional”)

gap between the two countries is larger in 2000 than it is in 1960. Spain starts

much poorer than the United States and the UK in 1960, but grows very rapidly

between 1960 and the mid-1970s, thus closing the gap between itself and the United

States and the UK. The three countries that show very rapid growth in this figure

are Singapore, South Korea and Botswana. Singapore starts much poorer than the

UK and Spain in 1960, but grows very rapidly and by the mid-1990s it has become

richer than both (as well as all other countries in this picture except the United

States). South Korea has a similar trajectory, but starts out poorer than Singapore

and grows slightly less rapidly overall, so that by the end of the sample it is still

a little poorer than Spain. The other country that has grown very rapidly is the

“African success story” Botswana, which was extremely poor at the beginning of

the sample. Its rapid growth, especially after 1970, has taken Botswana to the ranks

of the middle-income countries by 2000.

The two Latin American countries in this picture, Brazil and Guatemala, il-

lustrate the often-discussed Latin American economic malaise of the postwar era.

Brazil starts out richer than Singapore, South Korea and Botswana, and has a rela-

tively rapid growth rate between 1960 and 1980. But it experiences stagnation from

1980 onwards, so that by the end of the sample all three of these countries have

become richer than Brazil. Guatemala’s experience is similar, but even more bleak.

Contrary to Brazil, there is little growth in Guatemala between 1960 and 1980, and

no growth between 1980 and 2000.

Finally, Nigeria and India start out at similar levels of income per capita as

Botswana, but experience little growth until the 1980s. Starting in 1980, the Indian

economy experiences relatively rapid growth, but this has not been sufficient for

its income per capita to catch up with the other nations in the figure. Nigeria, on

the other hand, in a pattern all-too-familiar in sub-Saharan Africa, experiences a

13


contraction of its GDP per capita, so that in 2000 it is in fact poorer than it was in

1960.

The patterns shown in Figure 1.8 are what we would like to understand and

explain. Why is the United States richer in 1960 than other nations and able to grow

at a steady pace thereafter? How did Singapore, South Korea and Botswana manage

to grow at a relatively rapid pace for 40 years? Why did Spain grow relatively rapidly

for about 20 years, but then slow down? Why did Brazil and Guatemala stagnate

during the 1980s? What is responsible for the disastrous growth performance of

Nigeria?

1.4. Origins of Today’s Income Differences and World Economic Growth

These growth-rates differences shown in Figures 1.7 and 1.8 are interesting in

their own right and could also be, in principle, responsible for the large differences

in income per capita we observe today. But are they? The answer is No. Figure 1.8

shows that in 1960 there was already a very large gap between the United States on

the one hand and India and Nigeria on the other. In fact some of the fastest-growing

countries such as South Korea and Botswana started out relatively poor in 1960.

This can be seen more easily in Figure 1.9, which plots log GDP per worker in

2000 versus GDP per capita in 1960, together with the 45◦ line. Most observations

are around the 45◦ line, indicating that the relative ranking of countries has changed

little between 1960 and 2000. Thus the origins of the very large income differences

across nations are not to be found in the postwar era. There are striking growth

differences during the postwar era, but the evidence presented so far suggests that

the “world income distribution” has been more or less stable, with a slight tendency

towards becoming more unequal.

If not in the postwar era, when did this growth gap emerge? The answer is that

much of the divergence took place during the 19th century and early 20th century.

Figures 1.10, 1.11 and 1.13 give a glimpse of these 19th-century developments by

using the data compiled by Angus Maddison for GDP per capita differences across

nations going back to 1820 (or sometimes earlier). These data are less reliable than

Summers-Heston’s Penn World tables, since they do not come from standardized

national accounts. Moreover, the sample is more limited and does not include

14


ARG

AUSAUT

BDI

BEL

BENBFA

BGD BOL

BRA

BRB

CANCHE

CHL

CHN

CIVCMR

COG

COL

COM

CPV

CRI

DNK

DOM

ECU

EGY

ESP

ETH

FINFRA

GAB

GBR

GHA

GIN

GMB

GNB

GRC

GTM

HKG

HND

IDN

IND

IRL

IRN

ISLISRITA

JAM

JOR

JPN

KEN

KOR

LKA

LSO

LUX

MAR

MDG

MEX

MLIMOZ

MUS

MWI

MYS

NERNGA

NIC

NLDNOR

NPL

NZL

PAK

PAN

PERPHL

PRT

PRYROM

RWA

SEN

SLV

SWE

SYC

SYR

TCDTGO

THA

TTO

TUR

TZA

UGA

URY

USA

VENZAF

ZMB

ZWE

78

910

1112

log

gdp

per w

orke

r 200

0

6 7 8 9 10log gdp per worker 1960

Figure 1.9. Log GDP per worker in 2000 versus log GDP per workerin 1960, together with the 45◦ line.

observations for all countries going back to 1820. Finally, while these data do

include a correction for PPP, this is less reliable than the price comparisons used

to construct the price indices in the Penn World tables. Nevertheless, these are the

best available estimates for differences in prosperity across a large number of nations

going back to the 19th century.

Figures 1.10 shows the estimates of the distribution of countries by GDP per

capita in 1820, 1913 (right before World War I) and 2000. To facilitate comparison,

the same set of countries are used to construct the distribution of income in each

date. The distribution of income per capita in 1820 is relatively equal, with a very

small left tail and a somewhat larger but still small right tail. In contrast, by 1913,

there is considerably more weight in the tails of the distribution. By 2000, there are

much larger differences.

15


1820

19132000

0.5

11.

5D

ensi

ty o

f cou

tries

4 6 8 10 12log gdp per capita

Figure 1.10. Estimates of the distribution of countries according tolog GDP per capita in 1820, 1913 and 2000.

Figure 1.11 also illustrates the divergence; it depicts the evolution of average

income in five groups of countries, Western Offshoots of Europe (the United States,

Canada, Australia and New Zealand), Western Europe, Latin America, Asia and

Africa. It shows the relatively rapid growth of the Western Offshoots and West Eu-

ropean countries during the 19th century, while Asia and Africa remained stagnant

and Latin America showed little growth. The relatively small income gaps in 1820

become much larger by 2000.

Another major macroeconomic fact is visible in Figure 1.11: Western Offshoots

and West European nations experience a noticeable dip in GDP per capita around

1929, because of the Great Depression. Western offshoots, in particular the United

States, only recover fully from this large recession just before WWII. How an econ-

omy can experience such a sharp decline in output and how it recovers from such a

16


Western Offshoots

Western Europe

AfricaLatin America

Asia

67

89

10lo

g gd

p pe

r cap

ita

1800 1850 1900 1950 2000year

Figure 1.11. The evolution of average GDP per capita in WesternOffshoots, Western Europe, Latin America, Asia and Africa, 1820-2000.

shock are among the major questions of macroeconomics. While the Great Depres-

sion falls outside the scope of the current book, we will later discuss the relationship

between economic crises and economic growth as well as potential sources of eco-

nomic volatility.

A variety of other evidence suggest that differences in income per capita were

even smaller once we go back further than 1820. Maddison also has estimates for

average income per capita for the same groups of countries going back to 1000 AD or

even earlier. We extend Figure 1.11 using these data; the results are shown in Figure

1.12. While these numbers are based on scattered evidence and guesses, the general

pattern is consistent with qualitative historical evidence and the fact that income

per capita in any country cannot have been much less than $500 in terms of 2000

US dollars, since individuals could not survive with real incomes much less than this

17


level. Figure 1.12 shows that as we go further back, the gap among countries becomes

much smaller. This further emphasizes that the big divergence among countries has

taken place over the past 200 years or so. Another noteworthy feature that becomes

apparent from this figure is the remarkable nature of world economic growth. Much

evidence suggests that there was little economic growth before the 18th century and

certainly almost none before the 15th century. Maddison’s estimates show a slow

but steady increase in West European GDP per capita between 1000 and 1800. This

view is not shared by all historians and economic historians, many of whom estimate

that there was little increase in income per capita before 1500 or even before 1800.

For our purposes however, this is not central. What is important is that starting in

the 19th, or perhaps in the late 18th century, the process of rapid economic growth

takes off in Western Europe and among the Western Offshoots, while many other

parts of the world do not experience the same sustained economic growth. We owe

our high levels of income today to this process of sustained economic growth, and

Figure 1.12 shows that it is also this process of economic growth that has caused

the divergence among nations.

Figure 1.13 shows the evolution of income per capita for United States, Britain,

Spain, Brazil, China, India and Ghana. This figure confirms the patterns shown in

Figure 1.11 for averages, with the United States Britain and Spain growing much

faster than India and Ghana throughout, and also much faster than Brazil and

China except during the growth spurts experienced by these two countries.

Overall, on the basis of the available information we can conclude that the ori-

gins of the current cross-country differences in economic performance in income

per capita formed during the 19th century and early 20th century (perhaps during

the late 18th century). This divergence took place at the same time as a number

of countries in the world started the process of modern and sustained economic

growth. Therefore understanding modern economic growth is not only interesting

and important in its own right, but it also holds the key to understanding the causes

of cross-country differences in income per capita today.

18


Western Offshoots

Western Europe

Africa

LatinAmerica

Asia

67

89

10lo

g gd

p pe

r cap

ita

1000 1200 1400 1600 1800 2000year

Figure 1.12. The evolution of average GDP per capita in WesternOffshoots, Western Europe, Latin America, Asia and Africa, 1000-2000.

1.5. Conditional Convergence

We have so far documented the large differences in income per capita across

nations, the slight divergence in economic fortunes over the postwar era and the

much larger divergence since the early 1800s. The analysis focused on the “uncondi-

tional” distribution of income per capita (or per worker). In particular, we looked at

whether the income gap between two countries increases or decreases irrespective of

these countries’ “characteristics” (e.g., institutions, policies, technology or even in-

vestments). Alternatively, we can look at the “conditional” distribution (e.g., Barro

and Sala-i-Martin, 1992). Here the question is whether the economic gap between

two countries that are similar in observable characteristics is becoming narrower or

wider over time. When we look at the conditional distribution of income per capita

across countries the picture that emerges is one of conditional convergence: in the

19


USA

Britain

Spain

Ghana

Brazil

China

India

67

89

10lo

g gd

p pe

r cap

ita

1800 1850 1900 1950 2000year

Figure 1.13. The evolution of income per capita in the UnitedStates, Britain, Spain, Brazil, China, India and Ghana, 1820-2000.

postwar period, the income gap between countries that share the same character-

istics typically closes over time (though it does so quite slowly). This is important

both for understanding the statistical properties of the world income distribution

and also as an input into the types of theories that we would like to develop.

How do we capture conditional convergence? Consider a typical “Barro growth

regression”:

(1.1) gt,t−1 = β ln yt−1 +X0t−1α+ εt

where gt,t−1 is the annual growth rate between dates t− 1 and t, yt−1 is output perworker (or income per capita) at date t−1, and Xt−1 is a vector of variables that theregression is conditioning on with coefficient vector α These variables are included

because they are potential determinants of steady state income and/or growth. First

note that without covariates equation (1.1) is quite similar to the relationship shown

20


in Figure 1.9 above. In particular, since gt,t−1 ' ln yt − ln yt−1, equation (1.1) canbe written as

ln yt ' (1 + β) ln yt−1 + εt.

Figure 1.9 showed that the relationship between log GDP per worker in 2000 and

log GDP per worker in 1960 can be approximated by the 45◦ line, so that in terms

of this equation, β should be approximately equal to 0. This is confirmed by Figure

1.14, which depicts the relationship between the (geometric) average growth rate

between 1960 and 2000 and log GDP per worker in 1960. This figure reiterates

that there is no “unconditional” convergence for the entire world over the postwar

period.

ARG

AUS

AUT

BDI

BEL

BEN

BFA

BGD

BOL

BRA

BRB

CAN

CHE

CHL

CHN

CIV

CMR

COG

COL

COM

CPV

CRI

DNK

DOM

ECU

EGY

ESP

ETH

FINFRA

GAB

GBR

GHAGIN

GMB

GNB

GRC

GTM

HKG

HND

IDN

IND

IRL

IRN ISL

ISR

ITA

JAM

JOR

JPN

KEN

KOR

LKALSO

LUX

MAR

MDG

MEX

MLIMOZ

MUS

MWI

MYS

NERNGA NIC

NLD

NOR

NPL

NZL

PAK

PAN

PER

PHL

PRT

PRY

ROM

RWA

SEN

SLV

SWE

SYC

SYR

TCD

TGO

THA

TTO

TUR

TZA

UGA

URY

USA

VEN

ZAF

ZMB

ZWE

-.02

0.0

2.0

4.0

6an

nual

gro

wth

rate

196

0-20

00

6 7 8 9 10log gdp per worker 1960

Figure 1.14. Annual growth rate of GDP per worker between 1960and 2000 versus log GDP per worker in 1960 for the entire world.

21


While there is no convergence for the entire world, when we look among the

“OECD” nations,1 we see a different pattern. Figure 1.15 shows that there is a

strong negative relationship between log GDP per worker in 1960 and the annual

growth rate between 1960 and 2000 among the OECD countries. What distinguishes

this sample from the entire world sample is the relative homogeneity of the OECD

countries, which have much more similar institutions, policies and initial conditions

than the entire world. This suggests that there might be a type of conditional

convergence when we control for certain country characteristics potentially affecting

economic growth.

AUS

AUT

BEL

CAN

CHE

DNK

ESP

FIN

FRA

GBR

GRC

IRL

ISL

ITA

JPN

LUX

NLD

NOR

NZL

PRT

SWE

USA

.01

.02

.03

.04

annu

al g

row

th ra

te 1

960-

2000

9 9.5 10 10.5log gdp per worker 1960

Figure 1.15. Annual growth rate of GDP per worker between 1960and 2000 versus log GDP per worker in 1960 for core OECD countries.

This is what the vector Xt−1 captures in equation (1.1). In particular, when this

vector includes variables such as years of schooling or life expectancy, Barro and

1That is, the initial members of the OECD club plotted in this picture, which excludes morerecent OECD members such as Turkey, Mexico and Korea.

22


Sala-i-Martin estimate β to be approximately -0.02, indicating that the income gap

between countries that have the same human capital endowment has been narrowing

over the postwar period on average at about 2 percent a year.

Therefore, while there is no evidence of (unconditional) convergence in the world

income distribution over the postwar era (and in fact, if anything there is diver-

gence in incomes across nations), there is some evidence for conditional convergence,

meaning that the income gap between countries that are similar in observable char-

acteristics appears to narrow over time. This last observation is relevant both for

understanding among which countries the divergence has occurred and for determin-

ing what types of models we might want to consider for understanding the process

of economic growth and differences in economic performance across nations. For

example, we will see that many of the models we will study shortly, including the

basic Solow and the neoclassical growth models, suggest that there should be “tran-

sitional dynamics” as economies below their steady-state (target) level of income

per capita grow towards that level. Conditional convergence is consistent with this

type of transitional dynamics.

1.6. Correlates of Economic Growth

The discussion of conditional convergence in the previous section emphasized the

importance of certain country characteristics that might be related to the process

of economic growth. What types of countries grow more rapidly? Ideally, we would

like to answer this question at a “causal” level. In other words, we would like to

know which specific characteristics of countries (including their policies and institu-

tions) have a causal effect on growth. A causal effect here refers to the answer to the

following counterfactual thought experiment: if, all else equal, a particular charac-

teristic of the country were changed “exogenously” (i.e., not as part of equilibrium

dynamics or in response to a change in other observable or unobservable variables),

what would be the effect on equilibrium growth? Answering such causal questions

is quite challenging, however, precisely because it is difficult to isolate changes in

endogenous variables that are not driven by equilibrium dynamics or by some other

variables.

23


ARG

AUS

AUT

BDI

BEL

BENBFA

BGD

BOL

BRA

BRB

CAN

CHE

CHL

CHN

CIV CMR

COG

COL

COM

CPV

CRI

DNK

DOM

DZAECU

EGY

ESP

ETH

FINFRAGAB

GBR

GHA

GIN

GMB

GNB

GNQ

GRC

GTM

HKG

HND

IDN

IND

IRL

IRN

ISLISRITA

JAM

JOR

JPN

KEN

KOR

LKALSO

LUX

MAR

MDG

MEX

MLI

MOZ

MUS

MWI

MYS

NER

NGANIC

NLD

NOR

NPLNZL

PAK

PAN

PER

PHL

PRT

PRY

ROM

RWASEN

SLV

SWE

SYCSYR

TCD

TGO

THA

TTO TUR

TZA

UGAURY

USA

VEN

ZAF

ZMB

ZWE

-.02

0.0

2.0

4.0

6av

erag

e gr

owth

gdp

per

cap

ita 1

960-

2000

-.05 0 .05 .1 .15average growth investment 1960-2000

Figure 1.16. The relationship between average growth of GDP percapita and average growth of investments to GDP ratio, 1960-2000.

For this reason, we start with the more modest question of what factors correlate

with post-war economic growth. With an eye to the theories that will come in the

next two chapters, the two obvious candidates to look at are investments in physical

capital and in human capital.

Figure 1.16 shows a strong positive association between the average growth of

investment to GDP ratio and economic growth. Figure 1.17 shows a positive cor-

relation between average years of schooling and economic growth. These figures

therefore suggest that the countries that have grown faster are typically those that

have invested more in physical capital and those that started out the postwar era

with greater human capital. It has to be stressed that these figures do not imply

that physical or human capital investment are the causes of economic growth (even

though we expect from basic economic theory that they should contribute to in-

creasing output). So far these are simply correlations, and they are likely driven, at

24


ARG

AUS

AUT

BDI

BEL

BEN

BGD

BOL

BRA

BRB

CAN

CHE

CHL

CHN

CMR

COG

COL

CRI

DNK

DOM

DZA ECU

EGY

ESP

FINFRA

GBR

GHA

GMB

GRC

GTM

HKG

HND

IDN

IND

IRL

IRN

ISL ISRITA

JAM

JOR

JPN

KEN

KOR

LKALSO MEX

MLI

MOZ

MUS

MWI

MYS

NERNIC

NLD

NOR

NPLNZL

PAK

PAN

PER

PHL

PRT

PRY

RWASEN

SLV

SWE

SYR

TGO

THA

TTOTUR

UGA URY

USA

VEN

ZAF

ZMB

ZWE

-.02

0.0

2.0

4.0

6av

erag

e gr

owth

gdp

per

cap

ita 1

960-

2000

0 2 4 6 8 10average schooling 1960-2000

Figure 1.17

least in part, by omitted factors affecting both investment and schooling on the one

hand and economic growth on the other.

We will investigate the role of physical and human capital in economic growth

further in Chapter 3. One of the major points that will emerge from our analysis

there is that focusing only on physical and human capital is not sufficient. Both

to understand the process of sustained economic growth and to account for large

cross-country differences in income, we also need to understand why societies differ

in the efficiency with which they use their physical and human capital. We normally

use the shorthand expression “technology” to capture factors other than physical

and human capital affecting economic growth and performance (and we will do so

throughout the book). It is therefore important to remember that technology dif-

ferences across countries include both genuine differences in the techniques and in

25


the quality of machines used in production, but also differences in productive effi-

ciency resulting from differences in the organization of production, from differences

in the way that markets are organized and from potential market failures (see in

particular Chapter 22 on differences in productive efficiency resulting from the orga-

nization of markets and market failures). A detailed study of “technology” (broadly

construed) is necessary for understanding both the world-wide process of economic

growth and cross-country differences. The role of technology in economic growth

will be investigated in Chapter 3 and in later chapters.

1.7. From Correlates to Fundamental Causes

The correlates of economic growth, such as physical capital, human capital and

technology, will be our first topic of study. But these are only proximate causes of

economic growth and economic success (even if we convince ourselves that there is

a causal element the correlations shown above). It would not be entirely satisfac-

tory to explain the process of economic growth and cross-country differences with

technology, physical capital and human capital, since presumably there are reasons

for why technology, physical capital and human capital differ across countries. In

particular, if these factors are so important in generating large cross country income

differences and causing the takeoff into modern economic growth, why do certain

societies fail to improve their technologies, invest more in physical capital, and ac-

cumulate more human capital?

Let us return to Figure 1.8 to illustrate this point further. This figure shows

that South Korea and Singapore have managed to grow at very rapid rates over the

past 50 years, while Nigeria has failed to do so. We can try to explain the successful

performance of South Korea and Singapore by looking at the correlates of economic

growth–or at the proximate causes of economic growth. We can conclude, as many

have done, that rapid capital accumulation has been was very important in gener-

ating these growth miracles, and debate the role of human capital and technology.

We can blame the failure of Nigeria to grow on its inability to accumulate capital

and to improve its technology. These answers are undoubtedly informative for un-

derstanding the mechanics of economic successes and failures of the postwar era.

But at some level they will also not have answered the central questions: how did

26


South Korea and Singapore manage to grow, while Nigeria failed to take advantage

of the growth opportunities? If physical capital accumulation is so important, why

did Nigeria not invest more in physical capital? If education is so important, why

did the Nigerians not invest more in their human capital? The answer to these

questions is related to the fundamental causes of economic growth.

We will refer to potential factors affecting why societies end up with differ-

ent technology and accumulation choices as the fundamental causes of economic

growth. At some level, fundamental causes are the factors that enable us to link the

questions of economic growth to the concerns of the rest of social sciences, and ask

questions about the role of policies, institutions, culture and exogenous environmen-

tal factors. At the risk of oversimplifying complex phenomena, we can think of the

following list of potential fundamental causes: (i) luck (or multiple equilibria) that

lead to divergent paths among societies with identical opportunities, preferences and

market structures; (ii) geographic differences that affect the environment in which

individuals live and that influence the productivity of agriculture, the availability

of natural resources, certain constraints on individual behavior, or even individual

attitudes; (iii) institutional differences that affect the laws and regulations under

which individuals and firms function and thus shape the incentives they have for

accumulation, investment and trade; and (iv) cultural differences that determine

individuals’ values, preferences and beliefs. Chapter 4 will present a detailed discus-

sion of the distinction between proximate and fundamental causes and what types

of fundamental causes are more promising in explaining the process of economic

growth and cross-country income differences.

For now, it is useful to briefly return to South Korea and Singapore versus Nige-

ria, and ask the questions (even if we are not in a position to fully answer them

yet): can we say that South Korea and Singapore owe their rapid growth to luck,

while Nigeria was unlucky? Can we relate the rapid growth of South Korea and

Singapore to geographic factors? Can we relate them to institutions and policies?

Can we find a major role for culture? Most detailed accounts of post-war economics

and politics in these countries emphasize the growth-promoting policies in South

Korea and Singapore– including the relative security of property rights and invest-

ment incentives provided to firms. In contrast, Nigeria’s postwar history is one of

27


civil war, military coups, extreme corruption and an overall environment failing to

provide incentives to businesses to invest and upgrade their technologies. It there-

fore seems necessary to look for fundamental causes of economic growth that make

contact with these facts and then provide coherent explanations for the divergent

paths of these countries. Jumping ahead a little, it will already appear implausible

that luck can be the major explanation. There were already significant differences

between South Korea, Singapore in Nigeria at the beginning of the postwar era. It

is also equally implausible to link the divergent fortunes of these countries to geo-

graphic factors. After all, their geographies did not change, but the growth spurts

of South Korea and Singapore started in the postwar era. Moreover, even if we

can say that Singapore benefited from being an island, without hindsight one might

have concluded that Nigeria had the best environment for growth, because of its

rich oil reserves.2 Cultural differences across countries are likely to be important

in many respects, and the rapid growth of many Asian countries is often linked to

certain “Asian values”. Nevertheless, cultural explanations are also unlikely to pro-

vide the whole story when it comes to fundamental causes, since South Korean or

Singaporean culture did not change much after the end of WWII, while their rapid

growth performances are distinctly post-war phenomena. Moreover, while South

Korea grew rapidly, North Korea, whose inhabitants share the same culture and

Asian values, had one of the most disastrous economic performances of the past 50

years.

This admittedly quick (and perhaps partial) account suggests that we have to

look at the fundamental causes of economic growth in institutions and policies that

affect incentives to accumulate physical and human capital and improve technol-

ogy. Institutions and policies were favorable to economic growth in South Korea

and Singapore, but not in Nigeria. Understanding the fundamental causes of eco-

nomic growth is, in large part, about understanding the impact of these institutions

2One can then turn this around and argue that Nigeria is poor because of a “natural resourcecurse,” i.e., precisely because it has abundant and valuable natural resources. But this is not anentirely compelling empirical argument, since there are other countries, such as Botswana, withabundant natural resources that have grown rapidly over the past 50 years. More important, theonly plausible channel through which abundance of natural resources may lead to worse economicoutcomes is related to institutional and political economy factors. This then takes us to the realmof institutional fundamental causes.

28


and policies on economic incentives and why, for example, they have been growth-

enhancing in the former two countries, but not in Nigeria. The intimate link between

fundamental causes and institutions highlighted by this discussion motivates the last

part of the book, which is devoted to the political economy of growth, that is, to

the study of how institutions affect growth and why they differ across countries.

An important caveat should be noted at this point. Discussions of geography,

institutions and culture can sometimes be carried out without explicit reference

to growth models or even to growth empirics. After all, this is what many non-

economist social scientists do. However, fundamental causes can only have a big

impact on economic growth if they affect parameters and policies that have a first-

order influence on physical and human capital and technology. Therefore, an un-

derstanding of the mechanics of economic growth is essential for evaluating whether

candidate fundamental causes of economic growth could indeed play the role that

they are sometimes ascribed. Growth empirics plays an equally important role in

distinguishing among competing fundamental causes of cross-country income dif-

ferences. It is only by formulating parsimonious models of economic growth and

confronting them with data that we can gain a better understanding of both the

proximate and the fundamental causes of economic growth.

1.8. The Agenda

This discussion points to the following set of facts and questions that are central

to an investigation of the determinants of long-run differences in income levels and

growth. The three major questions that have emerged from our brief discussion are:

(1) Why are there such large differences in income per capita and worker pro-

ductivity across countries?

(2) Why do some countries grow rapidly while other countries stagnate?

(3) What sustains economic growth over long periods of time and why did

sustained growth start 200 years or so ago?

• In each case, a satisfactory answer requires a set of well-formulated modelsthat illustrate the mechanics of economic growth and cross-country income

differences, together with an investigation of the fundamental causes of the

29


different trajectories which these nations have embarked upon. In other

words, in each case we need a combination of theoretical models and em-

pirical work.

• The traditional growth models–in particular, the basic Solow and the neo-classical models–provide a good starting point, and the emphasis they

place on investment and human capital seems consistent with the patterns

shown in Figures 1.16 and 1.17. However, we will also see that technolog-

ical differences across countries (either because of their differential access

to technological opportunities or because of differences in the efficiency of

production) are equally important. Traditional models treat technology

(market structure) as given or at best as evolving exogenously like a black-

box. But if technology is so important, we ought to understand why and

how it progresses and why it differs across countries. This motivates our

detailed study of models of endogenous technological progress and tech-

nology adoption. Specifically, we will try to understand how differences in

technology may arise, persist and contribute to differences in income per

capita. Models of technological change will also be useful in thinking about

the sources of sustained growth of the world economy over the past 200

years and why the growth process took off 200 years or so ago and has

proceeded relatively steadily since then.

• Some of the other patterns we encountered in this chapter will inform usabout the types of models that have the most promise in explaining eco-

nomic growth and cross-country differences in income. For example, we

have seen that cross-country income differences can only be accounted for

by understanding why some countries have grown rapidly over the past

200 years, while others have not. Therefore, we need models that can ex-

plain how some countries can go through periods of sustained growth, while

others stagnate.

On the other hand, we have also seen that the postwar world income

distribution is relatively stable (at most spreading out slightly from 1960

to 2000). This pattern has suggested to many economists that we should

focus on models that generate large “permanent” cross-country differences

30


in income per capita, but not necessarily large “permanent” differences in

growth rates (at least not in the recent decades). This is based on the

following reasoning: with substantially different long-run growth rates (as

in models of endogenous growth, where countries that invest at different

rates grow at different rates), we should expect significant divergence. We

saw above that despite some widening between the top and the bottom, the

cross-country distribution of income across the world is relatively stable.

Combining the post-war patterns with the origins of income differences

related to the economic growth over the past two centuries suggests that we

should look for models that can account both for long periods of significant

growth differences and also for a “stationary” world income distribution,

with large differences across countries. The latter is particularly challenging

in view of the nature of the global economy today, which allows for free-flow

of technologies and large flows of money and commodities across borders.

We therefore need to understand how the poor countries fell behind and

what prevents them today from adopting and imitating the technologies

and organizations (and importing the capital) of the richer nations.

• And as our discussion in the previous section suggests, all of these questionscan be (and perhaps should be) answered at two levels. First, we can use

the models we develop in order to provide explanations based on the me-

chanics of economic growth. Such answers will typically explain differences

in income per capita in terms of differences in physical capital, human capi-

tal and technology, and these in turn will be related to some other variables

such as preferences, technology, market structure, openness to international

trade and perhaps some distortions or policy variables. These will be our

answers regarding the proximate causes of economic growth.

We will next look at the fundamental causes underlying these proximate

factors, and try to understand why some societies are organized differently

than others. Why do they have different market structures? Why do some

societies adopt policies that encourage economic growth while others put

up barriers against technological change? These questions are central to

31


a study of economic growth, and can only be answered by developing sys-

tematic models of the political economy of development and looking at the

historical process of economic growth to generate data that can shed light

on these fundamental causes.

Our next task is to systematically develop a series of models to understand the

mechanics of economic growth. In this process, we will encounter models that un-

derpin the way economists think about the process of capital accumulation, techno-

logical progress, and productivity growth. Only by understanding these mechanics

can we have a framework for thinking about the causes of why some countries are

growing and some others are not, and why some countries are rich and others are

not.

Therefore, the approach of the book will be two-pronged: on the one hand,

it will present a detailed exposition of the mathematical structure of a number of

dynamic general equilibrium models useful for thinking about economic growth and

macroeconomic phenomena; on the other, we will try to uncover what these models

imply about which key parameters or key economic processes are different across

countries and why. Using this information, we will then attempt to understand the

potential fundamental causes of differences in economic growth.

1.9. References and Literature

The empirical material presented in this chapter is largely standard and parts of

it can be found in many books, though interpretations and exact emphases differ.

Excellent introductions, with slightly different emphases, are provided in Jones’s

(1998, Chapter 1) and Weil’s (2005, Chapter 1) undergraduate economic growth

textbooks. Barro and Sala-i-Martin (2004) also present a brief discussion of the

stylized facts of economic growth, though their focus is on postwar growth and

conditional convergence rather than the very large cross-country income differences

and the long-run perspective emphasized here. An excellent and very readable

account of the key questions of economic growth, with a similar perspective to the

one here, is provided in Helpman (2005).

32


Much of the data used in this chapter comes from Summers-Heston’s Penn World

tables (latest version, Summers, Heston and Aten, 2005). These tables are the re-

sult of a very careful study by Robert Summers and Alan Heston to construct

internationally comparable price indices and internationally comparable estimates

of income per capita and consumption. PPP adjustment is made possible by these

data. Summers and Heston (1991) give a very lucid discussion of the methodology

for PPP adjustment and its use in the Penn World tables. PPP adjustment enables

us to construct measures of income per capita that are comparable across coun-

tries. Without PPP adjustment, differences in income per capita across countries

can be computed using the current exchange rate or some fundamental exchange-

rate. There are many problems with such exchange-rate-based measures. The most

important one is that they do not make an allowance for the fact that relative prices

and even the overall price level differ markedly across countries. PPP-adjustment

brings us much closer to differences in “real income” and “real consumption”. In-

formation on “workers” (active population), consumption and investment are also

from this dataset. GDP, consumption and investment data from the Penn World

tables are expressed in 1996 constant US dollars. Life expectancy data are from the

World Bank’s World Development Indicators CD-ROM, and refer to the average

life expectancy of males and females at birth. This dataset also contains a range of

other useful information. Schooling data are from Barro and Lee’s (2002) dataset,

which contains internationally comparable information on years of schooling.

In all figures and regressions, growth rates are computed as geometric averages.

In particular, the geometric average growth rate of variable y between date t and

t+ T is defined as

gt,t+T ≡µyt+Tyt

¶1/T− 1.

Geometric average growth rate is more appropriate to use in the context of income

per capita than the arithmetic average, since the growth rate refers to “proportional

growth”. It can be easily verified from this formula that if yt+1 = (1 + g) yt for all

t, then gt+T = g.

Historical data are from various works by Angus Maddison (2001, 2005). While

these data are not as reliable as the estimates from the Penn World tables, the

33


general patterns they show are typically consistent with evidence from a variety

of different sources. Nevertheless, there are points of contention. For example, as

Figure 1.12 shows, Maddison’s estimates show a slow but relatively steady growth

of income per capita in Western Europe starting in 1000. This is disputed by many

historians and economic historians. A relatively readable account, which strongly

disagrees with this conclusion, is provided in Pomeranz (2001), who argues that

income per capita in Western Europe and China were broadly comparable as late as

1800. This view also receives support from recent research by Allen (2004), which

documents that the lev

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